What an Emergency Fund Is and Why You Need One

You’ve probably heard of something called an “emergency fund,” also called a “rainy day” fund. It is probably one of the simplest and most basic pillars of personal finance, but that doesn’t mean most people do it. In fact, a recent Bankrate survey showed almost two-thirds of Americans don’t have enough savings to cover a $500 emergency!

Part of the reason for this is there are so many other things clamoring for our dollars. Beyond just the basic everyday expenses you have other important goals such as saving for retirement, buying a house and possibly saving for a child’s college.

And while all of these are good goals to have, in almost all instances they involve “locking up” funds for these purposes, making them poorly designed to act as sources for emergency funds. Take the common 401(k) plan for example. While it provides a lot of good incentives for folks to save for retirement, it can be very painful to have to tap into these accounts before you hit retirement age. While there are some exceptions, including hardship withdrawals and some loan capabilities, these options have their own pitfalls. And at the end of the day, the beauty of retirement funds is they are focused on long-term investments, which tend to be very volatile even while having the best long-term return potential. Selling investments at the wrong time can be tremendously hazardous to your financial health! (For related reading, see: 3 Keys to Successful Long-Term Investing.)

No, at the end of the day, an old-fashioned “rainy day” fund, as boring as it is, is vital to your economic well-being!

So Just What Is an Emergency Fund?

It is simply a bank account, usually a savings account, where you keep funds for emergency expenses. When looking for a place to start building this fund, you want to find a savings or money market account that pays at least a little interest, but more importantly, is separate from your daily checking account. It needs to be set aside so you think long and hard before dipping into it. Don´t worry too much about the interest rate, since this account is not an investment. Think of it more as insurance against life’s little problems that come along. Speaking of insurance, you’ll also want to make sure the account is FDIC-insured, which protects your money in case the bank goes bankrupt.

How Large Should an Emergency Fund Be?

Experts disagree on how much you need to have saved in an emergency fund. Suze Orman feels you should save eight months of expenses but Dave Ramsey recommends three to six months (and most Certified Financial Planners agree.) There is no perfect answer to this question, but you can look at your individual circumstances and choose the amount that makes the most sense.

Here are a few questions to consider:

  • Job situation — How secure is my income? Am I in an industry that often changes rapidly? Are there two incomes in the household, or are there kids and a spouse who rely on one income? Am I self-employed?
  • Health — How often do the members of the household get sick?
  • Investments — Are all my other investments tied up in stocks (which can swing wildly in value), real estate (which can be hard to sell) or retirement plans (which have penalties and taxes if liquidated)?

Who Should Build an Emergency Fund?

Sadly, many people find themselves in a vicious cycle of trying to pay off debt and getting hit with a financial emergency that causes them to go further into debt. So is it even possible to create an emergency fund while paying off debt?

While it may not be easy, building an emergency fund while paying off debt is not an impossible task. You just need a plan and a little hard work and dedication. First focus on saving at least $1,000 if you don’t have it. That should be an immediate goal that trumps all other goals. Of course, during this time you have to continue to pay the minimum payments on your all loans, including your credit cards, personal loans, mortgage, etc. Don’t stop making payments to your creditors, or your credit score will suffer and extra interest and fees will start to build.

Once you have saved up this basic account, you can begin to focus on eliminating your debt. Choose between two excellent debt elimination strategies. Pick the one that works for you and go to town. While you are paying down the debt, take a piece of your free cash flow and continue to build your emergency fund.

So which do you prioritize over the other? First accumulate an emergency fund balance of at least one month of your take-home pay. Once you have at least one month of take home pay in your emergency fund, you have much more flexibility. From there, take a look at your interest rates. The higher your rates are, the more you should focus your efforts on debt repayment over the emergency fund. If you have high-interest debts such as payday loans or credit cards, obviously you would want to get rid of this debt as fast as possible. Shift your focus from the emergency fund, but do not neglect it completely.

Life is unpredictable. It has a habit of throwing unexpected expenses your way at different times and an emergency fund can be a lifesaver in these scenarios. But the trouble for most people is they have too many other things calling for their dollars’ attention. Despite all the other worthy goals and opportunities, you would be wise not to neglect your emergency fund. It can be the thing that stands between you and serious financial problems.

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